Strategic use of disclosure policy in distressed firms

Disclosure practices of financially distressed firms are subject to intense scrutiny by the investment community and therefore assume strategic importance. It can be argued that these firms are less forthcoming about their financial health. In contrast, I propose that some firms increase the quality of voluntary disclosures to convey confidence of eventual survival even at the cost of short-run valuation effects. I employ a proprietary instrument to measure the quality of disclosures in the Management Discussion and Analysis and examine 136 firms entering financial distress for the first time between 1990 and 1995. Disclosure quality increases in the initial year of distress. Sustained increases are limited to firms that subsequently recover. These results obtain after controlling for other relevant firm characteristics, and suggest that disclosure quality may be a useful contemporaneous input for bankruptcy prediction models.; Results from the first portion of the study are consistent with the proposition that managers attempt to differentiate their firms through disclosure quality; it is a logical step to test the market response to these shifts. Results are inconclusive, largely due to econometric problems presented by the nature of the sample. Changes in the cost of equity capital are evaluated through cross-period shifts in equity betas and book-to-market (BTM) factors. On average, there is no relationship between shifts in disclosure quality and contemporaneous shifts in these factors across the onset of distress. When the change in disclosure leads the change in cost of capital (managers disclose preemptively), the relationship between disclosure and the book-to-market factor is strong and negative for the smallest firms and insignificant for larger firms.; There is clear and robust evidence that managers alter disclosure quality in a way that should provide valuable information to market participants. The lack of a consistently clear market response to those shifts may well arise from econometric problems unrelated to the validity of the underlying theory rather than from a lack of effect on market participants. Future research would benefit from exploring the longitudinal relationships between disclosure quality and the cost of equity capital in a sample more representative of the overall population of firms.